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August 7, 2023 | In the wake of last week’s credit downgrade of the United States, a number of analysts are turning their attention to the next shoes to drop. Many are worried about bank failures, but what about sovereign defaults? Major cities such as Seattle, Portland, San Francisco, LA, St Louis, Memphis, Chicago, Philadelphia, NYC, Baltimore and even Washington, D.C. all seem headed for credit ratings downgrades in the next year.
“Are all losing tax revenue, population, and absorbing illegals,” one prominent banker argues in a weekend missive. ”Money is moving away. Corp HQs and affluent taxpayers, who pay most of city and state taxes, are heading south.” Here at WGA, we can think of at least four corporate clients that have moved HQ out of the New York metro area in the past two years.
As large, heavily indebted cities are hit with credit downgrades, these systemic events will make it difficult for failing issuers to sell new bonds, accelerating the process of default and debt deflation. Several observers foresee a scenario where the US Treasury, joined by several financially crippled cities, will come to market together, possibly dragging down the credit of the US just months before a general election.
Neither President Joe Biden nor Treasury Secretary Janet Yellen have anything to say about debt reduction, at least not for public consumption. And the leading Republican candidate, the indicted felon and former President Donald Trump, likewise is not known for spending a lot of time talking about deficit reduction. We suspect that a US fiscal crisis before the 2024 election will likely help the political fortunes of President Trump, but his re-election will take the US down the path to eventual debt default.
One of the things that supporters of President Trump fail to notice is that his government was largely dysfunctional, especially after the 2017 Charlottesville debacle. Once former Goldman Sachs (GS) banker Gary Cohn left the White House in 2018, the Trump Administration descended into chaos. Only the Treasury under Secretary Steven Mnuchin (2017-2021) showed any cohesion.
Cohn, who was the 11th Director of the National Economic Council and chief economic advisor to President Donald Trump from 2017 to 2018, was the glue that held the Trump project together from a managerial perspective. Ponder the fact that in the two years following the departure of Cohn, President Trump could not manage to sign the revisions for Executive Order 12866, perhaps the most important conservative project on the agenda. Secretary Mnuchin and the career staff at Treasury opposed EO 12866, of note.
Whether we have Donald Trump or Joe Biden in the White House next Christmas, the US seems to be on a trajectory to a financial crisis. “The US Treasury boosted the size of its quarterly bond sales for the first time in 2 1/2 years to help finance a surge in budget deficits so alarming it prompted Fitch Ratings to cut the government’s AAA credit rating a day earlier,” Bloomberg reports. As the White House ostensibly is preparing to win another four year term, the Biden Administration is seemingly sleepwalking into a sovereign debt crisis.
With yields on the 10-year Treasury now well-above 4%, the losses on legacy bonds and loans on the books of US banks will surge, along with the cost of funding to the Treasury, US cities and states, and banks and other private issuers. Since the FOMC shows no indication that it will accelerate the reduction of its balance sheet, the yield curve inversion will continue – even as residential home prices in markets outside of the great northern cities continue to appreciate.
We have been focused on the rising levels of multifamily loan defaults for the past several years, in part because once prime bank paper has normalized and then some since 2021. “From the third quarter of 2023 through the end of 2025, a record number of CMBS multifamily loans will come due, and it looks to be messy,” notes The Real Deal. Messy is an understatement. As the chart below illustrates, loss given default on prime bank multifamily loans are already at pre-COVID levels.
hSource: FDIC/WGA LLC
As the once premium debt stack comprised of Treasury and municipal debt heads for the waste bin, it is not surprising that Apollo Global Management (APO) CEO Marc Rowan told the FT of the end of the golden age of private equity buyouts. Since the Fed and other central banks seem to be done with massive asset price inflation, returns in the $4 trillion PE industry will no longer be driven by ever rising valuations.
When valuations fall, of course, loss given default rises. Apollo Commercial Real Estate Finance, the real estate investment trust arm of APO, wrote off a junior mezzanine B loan at 111 West 57th Street in Midtown West, Bloomberg reports. The write-off comes with an $82 million hit for the REIT. There are many, many more of these types of losses being incurred in private transactions.
The bond market gave up the equivalent of July’s performance in the first couple of days of August, suggesting that things will only get better with time. We almost tossed the WeetaBix this weekend when we read that Tiger Global is accumulating a large position in APO, this in search of diversification far beyond tech. Really?
The trouble with the Tiger Global strategy is that it seems to go against the sage wisdom of Rowan and his colleagues in the world of multi-asset management. The days of the FOMC bidding up EBITDA multiples into the teens on new business services firms is over. Likewise, the efficacy of holding mortgage lenders like AmeriHome was clearly ending at the end of QE. Rowan’s Athene (ATH) platform was a seller. Pay attention.
With the Treasury Borrowing Advisory Committee (TBAC) now in charge of monetary policy, look for rates from the belly of the curve out to 30s to rise. Didn’t we hear former PIMCO bond manager and fisherman Paul McCulley wax ecstatic over the belly of the Treasury curve on CNBC couple of weeks ago? When we heard that comment, our eyebrows hitched. Then TBAC did its thing.
“Going forward for nominals, I’d expect 2s, 5s and 10s to be more heavily leaned on, while 7s and 20s see relatively smaller increases, writes Charlie McElligott at Nomura (NMR). “For TIPS, the increase in 5s was a departure from the calendar year-based approach. Small increases to the next new issue 10s seem likely. TBAC’s debt optimization modeling prefers belly issuance, small TIPS increases, and if low term premium persists, increases in longer dated issuance.”
If the 10-year Treasury rises to say 4.5%, then the losses on the books of US banks, REITS and other holders of bonds will surge. If we assume that the average coupon in the $13 trillion asset mortgage complex is now 3.5% vs 3% a year ago, the industry will still report $750 million in negative AOCI in Q3 2023. More importantly, healthy banks will balk at buying troubled banks.
Imagine this scenario, informed by the fact that neither Secretary Yellen nor Fed Chairman Jerome Powell have the guts to stand up in public and demand that Congress reduce the federal deficit, now. Treasury slides into a debt crisis later this year after Moody’s finally downgrades the United States. The failure of several more regional banks could force the Fed to ease interest rates, but the resulting bond market rally will result in margin calls that could take down several heavily leveraged nonbanks. Stay tuned.
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